Example

Marginal Costing Principles

Diana & Co makes a product, the Splash, which has a variable production cost of $6
per unit and a sales price of $10 per unit. At the beginning of September 2018, there
were no opening inventories and production during the month was 20,000 units.
Fixed costs for the month were $45,000 (production, administration, sales and
distribution). There were no variable marketing costs.

Calculate the contribution and profit for September 2018, using marginal costing
principles, if sales were as follows:

a. 10,000 Splashes

b. 15,000 Splashes

c. 20,000 Splashes

Solution:

10,000 Splashes 15,000 Splashes 20,000 Splashes

$ $ $ $ $ $
Sales at ($10) 100,000 150,000 200,000
Opening Inventory 0 0 0
Variable Production 120,000 120,000 120,000
Cost
120,000 120,000 120,000
Less: Closing (60,000) (30,000) (-------)
Inventory (at
marginal cost)
Variable Cost of 60,000 90,000 120,000
Sales
Contribution 40,000 60,000 80,000
Less: Fixed Costs (45,000) (45,000) (45,000)
Profit/(Loss) (5,000) 15,000 35,000
Profit/(Loss) per unit (0.50) 1 1.75
Contribution per unit 4 4 4

The conclusions which may be drawn from this example are as follows:

a. The profit per unit varies at differing levels of sales, because the average
fixed overhead cost per unit changes with the volume of output and sales.
b. The contribution per unit is constant at all levels of output and sales. Total
contribution, which is the contribution per unit multiplied by the number of
units sold, increases in direct proportion to the volume of sales.
c. Since the contribution per unit does not change, the most effective way of
calculating the expected profit at any level of output and sales would be as
follows:

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 i. First calculate the total contribution.
ii. Then deduct fixed costs as a period charge in order to find the profit.
d. In this example the expected profit from the sale of 17,000 Splashes would be
as follows:

$
Total contribution (17,000 x $4) 68,000
Less fixed costs 45,000
Profit 23,000

i. If total contribution exceeds fixed costs, a profit is made.

ii. If total contribution exactly equals fixed costs, no profit or loss is made.
iii. If total contribution is less than fixed costs, there will be a loss.

Example

Mill Stream makes two products, the Mill and the Stream. Information relating to
each of these products for April 2018 is as follows:

Mill Stream
Opening inventory - -
Production (units) 15,000 6,000
Sales (units) 10,000 5,000

Sales price per unit $20 $30

$ $
Direct materials 8 14
Direct labour 4 2
Variable production overhead 2 1
Variable sales overhead 2 3

Fixed costs for the month $

Production costs 40,000
Administration costs 15,000
Sales and distribution costs 25,000

Required:

(a) Using marginal costing principles, calculate the profit in April 2018.
(b) Calculate the profit if sales had been 15,000 units of Mill and 6,000 units of
Stream.

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Solution:

(a)

$
Contribution from Mills (unit contribution = $20 – $16 = $4 x 10,000) 40,000

Contribution from Streams (unit contribution = $30 – $20 = $10 x 50,000

5,000)

Total contribution 90,000

Fixed costs for the period 80,000

Profit 10,000

(b)

$
Contribution from sales of 15,000 Mills (x $4) 60,000

Contribution from sales of 6,000 Streams (x $10) 60,000

Total contribution 120,000

Fixed costs for the period 80,000

Profit 40,000

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 Example: Marginal and absorption costing compared

Big Woof Co manufactures a single product, the Bark, details of which are as
follows.

Per unit $
Selling price 180.00
Direct materials 40.00
Direct labour 16.00
Variable overheads 10.00

Annual fixed production overheads are budgeted to be $1.6 million and Big Woof
expects to produce 1,280,000 units of the Bark each year. Overheads are absorbed
on a per unit basis. Actual overheads are $1.6 million for the year.

Budgeted fixed selling costs are $320,000 per quarter.

Actual sales and production units for the first quarter of 2018 are given below.

January-March
Sales 240,000 units
Production 280,000 units

There is no opening inventory at the beginning of January.

Prepare statements of profit or loss for the quarter, using:

(a) Marginal costing (b) Absorption costing

Solution:

Step 1 Calculate the overhead absorption rate per unit

Overhead absorption rate=Budgeted ¿ overhead ¿

Budgeted units

You are dealing with a three month period but the figures in the question are for a
whole year. You will have to convert these to quarterly figures.

$ 1.6 Million
Budgeted overheads ( quarterly ) = =$ 400,000
4

1,280,000
Budgeted production ( quarterly )= =320,000units
4

$ 400,000
Overhead absorption rate per unit= =$ 1.25 per unit
320,000units

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Step 2 Calculate total cost per unit

Total cost per unit ( Absorption costing )=Variable cost +¿ production cost

Total cost per unit ( Absorption costing )= ( 40+16+10 )+1.25=$ 67.25

Total cost per unit ( Marginal costing )=Variable cost=$ 66

Step 3 Calculate closing inventory in units

Closing inventory=Opening inventory + production – sales

Closing inventory=0+280,000 – 240,000=40,000units

Step 4 Calculate under/over absorption of overheads

This is based on the difference between actual production and budgeted production.

Actual production = 280,000 units

Budgeted production = 320,000 units (see Step 1 above)

Under-production = 40,000 units

As Big Woof produced 40,000 fewer units than expected, there will be an under
absorption of overheads of 40,000 x $1.25 (see Step 1 above) = $50,000.

This will be added to production costs in the statement of profit or loss.

Step 5 Produce statements of profit or loss

Marginal Costing Absorption Costing

$000 $000 $000 $000
Sales (240,000 x $180) 43,200 43,200
Less cost of sales:
Opening inventory 0 0
Plus: production cost
280,000 x $66 18,480
280,000 x $67.25 18,830
Less: Closing inventory
40,000 x $66 (2,640)
40,000 x $67.25 (2,690)
(15,840) 16,140
Add under-absorbed O/H 50
(16,190)
27,360
Contribution 27,010
Gross Profit
Less: 400 NIL
Fixed production O/H 320 320
Fixed selling O/H (720) (320)
26,640 26,690
Net profit

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 No Changes in Inventory

You will notice from the calculations in the example that there are differences
between marginal and absorption costing profits.

Before we go on to reconcile the profits, how would the profits for the two different
techniques differ if there were no changes between opening and closing inventory
(that is, if production = sales)?

For the first quarter we will now assume that sales were 280,000 units.

Marginal Costing Absorption Costing

$000 $000 $000 $000
Sales (280,000 x $180) 50,400 50,400
Less cost of sales:
Opening inventory 0 0
Plus: production cost
280,000 x $66 18,480
280,000 x $67.25 18,830
Less: Closing inventory NIL NIL
(18,480) 18,830
Add under-absorbed O/H 50
18,880
31,920
Contribution 31,520
Gross Profit
Less: 400
Fixed production O/H NIL
320 320
Fixed selling O/H (720) (320)
31,200 31,200
Net profit

Reconciling Profits

The profits reported under absorption costing and marginal costing for January to
March in the Big Woof question above can be reconciled as follows:

$’000

Marginal costing profit 26,640

Adjust for fixed overhead included in inventory: Inventory increase of 50

40,000 units x $1.25

Absorption costing profit 26,690

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 Question

The overhead absorption rate for product X is $10 per machine hour. Each unit of
product X requires 5 machine hours. Inventory of product X on 1 st January 2018 was
150 units and on 31st January 2018 it was 100 units.

What is the difference in profit between results reported using absorption costing and
results reported using marginal costing?

a) The absorption costing profit would be $2,500 less.

b) The absorption costing profit would be $2,500 greater.
c) The absorption costing profit would be $5,000 less.
d) The absorption costing profit would be $5,000 greater.

Solution

Difference in profit = change in inventory levels x fixed overhead absorption per unit
= (150 – 100) x $10 x 5 = $2,500 lower profit, because inventory levels decreased.
The correct answer is therefore option A.

The key is the change in the volume of inventory. Inventory levels have decreased
therefore absorption costing will report a lower profit. This eliminates options B and
D. Option C is incorrect because it is based on the closing inventory only (100 units x
$10 x 5 hours).

Question

When opening inventories were 8,500 litres and closing inventories 6,750 litres, a
firm had a profit of $62,100 using marginal costing.

Assuming that the fixed overhead absorption rate was $3 per litre, what would be the
profit using absorption costing?

a) $41,850
b) $56,850
c) $67,350
d) $82,350

Solution

Difference in profit = (8,500 – 6,750) x $3 = $5,250

Absorption costing profit = $62,100 – $5,250 = $56,850

The correct answer is B.

Since inventory levels reduced, the absorption costing profit will be lower than the
marginal costing profit. You can therefore eliminate options C and D.

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 Question

Last month a manufacturing company's profit was $2,000, calculated using

absorption costing principles. If marginal costing principles have been used, a loss
of $3,000 would have occurred.

The company's fixed production cost is $2 per unit. Sales last month were 10,000
units.

What was last month's production (in units)?

a) 7,500
b) 9,500
c) 10,500
d) 12,500

Solution

The correct answer is D.

Any difference between marginal and absorption costing profit is due to changes in
inventory.

$
Absorption costing profit 2,000
Marginal costing loss (3,000)
Difference 5,000

Change in inventory = Difference in profit/fixed product cost per unit

= $5,000/$2 = 2,500 units

Marginal costing loss is lower than absorption costing profit therefore inventory has
gone up – that is, production was greater than sales by 2,500 units.

Production = 10,000 units (sales) + 2,500 units = 12,500 units

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Question:

X plc produces one product – desks.

Each desk is budgeted to require 4 kg of wood at $3 per kg, 4 hours of labour at $2

per hour, and variable production overheads of $5 per unit.

Fixed production overheads are budgeted at $20,000 per month and average
production is estimated to be 10,000 units per month.

The selling price is fixed at $35 per unit.

There is also a variable selling cost of $1 per unit and fixed selling cost of $2,000 per
month.

During the first two months, X plc expects the following levels of activity:

January February

Production 11,000 units 9,500 units

Sales 9,000 units 11,500 units

All other results were as budgeted.

(a) Prepare a cost card using marginal costing

(b) Set out Profit Statements for the months of January and February using
absorption costing principles.

(c) Set out Profit Statements for the months of January and February using marginal
costing principles.

Solution:

(a) Cost cards:

Per unit ($)

Materials (4kg × $3) 12

Labour (4hrs × $2) 8

Var. overheads 5

Fixed overheads ($20,000/10,000) 2

Cost Price 27

Selling price 35

Standard profit 8

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(b)

$ $ $ $
January February
Sales (9,000 x 35) 315,000 11,500 x 35) 402,500
Cost of Sales:
Opening Inventory (2,000 x 27) 54,000
Materials (11,000 x 12) 132,000 (9,500 x 12) 114,000
Labour (11,000 x 8) 88,000 (9,500 x 8) 76,000
Variable O/H (11,000 x 5) 55,000 (9,500 x 5) 47,500
Fixed O/H (11,000 x 2) 22,000 (9,500 x 2) 19,000
297,000 310,500
Less: Closing Inventory (2,000 x 27) (54,000) -
(243,000) (310,500)
Standard Gross Profit (9,000 x 8) 72,000 (11,500 x 8) 92,000
Under/Over Absorption Actual: 2,000 Actual: 20,000 (1,000)
20,000 Absorbed: 19,000
Absorbed:
22,000
Actual Gross Profit 74,000 91,000
Less: Selling Costs
Variable (9,000 x 1) (9,000) (11,500 x 1) (11,500)
Fixed (2,000) (2,000)
Net Profit 63,000 77,500

(c)

$ $ $ $
January February
Sales (9,000 x 35) 315,000 11,500 x 35) 402,500
Cost of Sales:
Opening Inventory (2,000 x 25) 50,000
Materials (11,000 x 12) 132,000 (9,500 x 12) 114,000
Labour (11,000 x 8) 88,000 (9,500 x 8) 76,000
Variable O/H (11,000 x 5) 55,000 (9,500 x 5) 47,500
275,000 287,500
Less: Closing Inventory (2,000 x 25) (50,000) -
Less: V. Selling Costs (9,000 x 1) 9,000 (11,500 x 1) 11,500
(234,000) (299,000)
Contribution (9,000 x 10) 81,000 (11,500 x 8) 103,500
Less: Fixed Selling (2,000) (2,000)
Cost (20,000) (20,000)
Fixed Production Cost
Net Profit 59,000 81,500

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